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Why Europe's insurers can't stop buying bonds

Solvency II has pushed firms to run positive duration gaps

Recent research provides an insight into how insurers are dealing with life in the long shadow of central bank policy – suggesting European insurers are resigned to rates staying interminably low and have taken to running positive duration gaps.

About half of European firms taking part in the recently released Milliman Derivatives Survey say the duration of their assets over liabilities is greater than one year, compared with none of the participants in the previous year's survey running such a positive duration gap. Fewer than one-third of respondents report a negative gap. US insurers, by contrast, are evenly balanced, showing little change.

Why are Europeans adding to duration when yields are so low? The likely reason is careful management of their Solvency II balance sheet. The risk margin, in particular, leaves firms exposed to a fall in rates such that a positive duration gap makes sense even when rates are at rock-bottom levels and unlikely to fall further.

In the UK, the difference is even more marked, with about seven in 10 insurers reporting a positive duration gap. This approach means firms are left exposed to rates rising. But the evidence so far shows they are choosing to put Solvency II balance sheet stability first, perhaps ahead of a different economic view.

Meanwhile, firms in both the US and Europe are also struggling to settle on a suitable discount rate for assets and liabilities. The trend of insurers switching steadily over recent years to discounting assets using overnight indexed swap (OIS) rates has seen some reversal, says Milliman.

Only about one-third of insurers globally in the survey say they are valuing assets using OIS rates with a further 6% planning to do so in the near future – versus a clear trend in the opposite direction over the previous two years in the US, Europe and the UK.

In Europe, for example, the share of firms using or planning to use OIS discounting for assets collapsed from more than four-fifths to less than two-fifths year on year.

Here, the likely reason is uncertainty among insurers about the future of benchmarking rates in swaps markets, given initiatives to move away from Libor – discouraging firms from investing time and money to include OIS discounting in valuation models.

But the move leaves insurers with a difference between how swaps are valued on the risk management balance sheet and by dealer counterparties – a difference that would crystallise should they unwind the swaps in question.

Ironically, it seems regulators' efforts to establish more robust and credible risk-free rates in derivatives markets are pushing insurers – at least for now – back to their old ways.